Euro weakens as traders look ahead to monetary policy decisions from Fed and ECB

EUR/USD slips as the Euro comes under pressure from US Dollar strength and concerns over France's finances.
Unchanged interest rates are expected from both the Fed and the ECB as traders look ahead to this week's policy announcements.
Expectations for December policy action could shift with the release of US inflation data and Eurozone growth numbers.

Pressure on the Euro (EUR) has pushed EUR/USD modestly lower on Monday, with the US Dollar (USD) recovering ahead of this week’s monetary policy announcements from the Federal Reserve (Fed) and the European Central Bank (ECB). Adding to the strain on the single currency are France’s deteriorating fiscal prospects and pressures in the bond market.

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Trading near 1.1183 at the time of writing, the pair is 0.17% lower on the day. Meanwhile, the US Dollar Index (DXY) stands around 101.99. The index, which measures the Greenback against a basket of six major currencies, touched 101.45 last week, its weakest reading since 1 October.

Markets widely anticipate no change in interest rates when the Fed delivers its decision on Wednesday and the ECB follows on Thursday. Both central banks continue to face inflation above their respective 2% targets, with energy costs rising amid Middle East tensions and keeping inflation risks skewed upwards. Traders expect both banks to raise rates in December, so signals on the policy path could provoke a larger market response than the rate decisions themselves.

Can the Euro withstand higher oil prices as inflation expectations outpace the ECB response?

The latest increase in oil prices poses a particular challenge for the Euro, according to Commerzbank: “higher oil prices in particular should put greater pressure on the euro, as their impact on both inflation and economic activity in the euro area is more pronounced and, on balance, negative for the currency.” Highlighting the divergence with the US, the bank says “short-term inflation expectations have risen more strongly in the euro area than in the US,” while “higher inflation expectations are currently not being offset by a corresponding shift in relative interest-rate expectations.” Commerzbank’s overall assessment is that “this is, in principle, a negative signal for the euro.”

Wider French spreads have, however, yet to trigger broader stress across the Eurozone, the bank points out, adding that “this suggests that the market currently views the fiscal concerns largely as a French problem.” For Commerzbank, “one possible explanation” is “the expectation that the ECB would intervene if contagion became more pronounced, thereby limiting the risk of broader fragmentation in the euro-area bond market.”

A packed data calendar offers further potential drivers for EUR/USD this week, alongside the central bank announcements. Due from the US on Tuesday are the ADP employment report, September Durable Goods Orders, October Consumer Confidence and September New Home Sales. On Thursday, attention turns to September Personal Consumption Expenditures (PCE) inflation, the advance third-quarter Gross Domestic Product (GDP) estimate and weekly Initial Jobless Claims.

Thursday’s Eurozone calendar features October readings on the business climate, consumer confidence and economic sentiment. Preliminary third-quarter GDP and the bloc’s unemployment rate follow on Friday, together with Germany’s preliminary October Consumer Price Index (CPI).

Questions about the ECB

How does the ECB work, and what does it mean for the Euro?

Based in Frankfurt, Germany, the European Central Bank (ECB) serves as the Eurozone’s reserve bank, setting interest rates and overseeing the region’s monetary policy. Maintaining price stability is its main mandate, with the aim of keeping inflation around 2%. To achieve this, the ECB primarily adjusts interest rates upwards or downwards. Higher rates will generally support a stronger Euro, while lower rates tend to have the opposite effect. Monetary policy is decided by the ECB Governing Council at eight meetings each year. The decision-makers comprise the heads of Eurozone national banks and six permanent members, among them ECB President Christine Lagarde.

How does Quantitative Easing (QE) work, and why does it affect the Euro?

When conditions become extreme, the European Central Bank may turn to Quantitative Easing (QE). Under this policy, the ECB prints Euros to purchase assets, generally government or corporate bonds, from banks and other financial institutions. The Euro usually weakens as a result of QE. Reserved as a last resort, QE is used when interest rate cuts alone are unlikely to deliver price stability. The ECB deployed it during the Great Financial Crisis in 2009-11, again in 2015 amid persistently low inflation, and during the COVID pandemic.

How does Quantitative tightening (QT) work, and why can it support the Euro?

Once an economic recovery takes hold and inflation begins to climb following QE, central banks may undertake its reverse, Quantitative tightening (QT). During QE, the European Central Bank (ECB) supplies liquidity to financial institutions by purchasing government and corporate bonds from them. Under QT, it ends further bond purchases and no longer reinvests the principal repaid as bonds in its existing holdings mature. This is generally supportive of, or bullish for, the Euro.